This is National Small Business Week and, to kick things off, the SEC today held a brief roundtable featuring representatives of small business and investment funds in a discussion of the challenges of raising funding outside of the four key tech hotspots (San Francisco, San Jose, Boston and NYC) as well as other challenges associated with public company status as a small business. After the roundtable, the SEC’s Small Business Capital Formation Advisory Committee held its inaugural meeting. At the meeting, Corp Fin Director Bill Hinman discussed the SEC’s agenda (including the upcoming proposal that could limit the application of the SOX 404(b) auditor attestation requirement).
(Based solely on my notes, so standard caveats apply.)
Apparently, only 13% of capital raised by deal flow occurs “between the coasts,” and, as a result, the challenges of raising capital in that area are real, particularly in areas with low population density. According to the SEC, “[v]enture-backed companies in the U.S. raised over $99 billion across over 5,000 deals in 2018, yet companies in just three states accounted for over three-quarters of that funding.” Are there ways the SEC could encourage funding outside of the traditional investing hotspots? Panelists suggested that the SEC consider ways to incentivize investors to invest in the mid-west, similar to the concept of opportunity zones. As an analogy, one panelist pointed to the South Carolina angel tax credit, which provides a credit for investments in the designated zone that amount to 35% of the investor’s portfolio.
The SEC was also encouraged by panelists to do more to facilitate secondary trading and the development of secondary markets, as many investors are deterred by the risk associated with the long time horizon for many investments.
Another issue raised was the limited percentage of accredited investors that actually participate in this type of investing (300,000 out of 10M eligible accredited investors). What could the SEC do to encourage more eligible investors to participate in private investments? Further education was one possibility mentioned, as it was suggested that many potential investors don’t really know how to participate. One panelist raised the concern that the SEC might increase the accredited investor threshold, which, he suggested, could eliminate more than half of the angel investors and adversely affect female and minority investors in particular.
From the perspective of small public companies, the panelists advocated that the SEC look at easing the burden on smaller companies with regard to SOX 404(b), the requirement for an auditor attestation regarding internal control (which, Hinman advised the Committee, will be addressed when the SEC considers proposing new rule amendments to the accelerated filer and large accelerated filer definitions later this week). A panelist representing a public company also raised as an issue the high costs associated with changes to the accounting standards for revenue recognition and leases.
At the Small Business Capital Formation Advisory Committee, SEC Chair Jay Clayton stressed the importance of allowing retail investors to participate in early stage investments; however, from an investor protection standpoint, a key is to ensure that the interests of retail investors are aligned with those of management and the institutional investors.
In addition, Director Hinman solicited the Committee’s thoughts on a number of the Corp Fin’s agenda items:
- The concept release, currently in process, aimed at harmonizing the patchwork universe of private placement exemptions. The objective would be a system that is better suited to the business life cycle of companies. As part of that review, the staff is looking at whether it still made sense to retain the accredited investor definition as it currently stands—as a binary test, in which, if you do not exceed the threshold, you cannot participate at all, but if you do exceed the threshold, you can participate to any extent in the transaction. Alternatively, it might be more appropriate to scale the level of investment permitted relative to the wealth of individual. Hinman noted that the concept release would fold in prior recommendations from the Committee’s predecessors.
In 2015, the SEC issued a staff report, required under Dodd-Frank, on the staff’s review of the accredited investor definition. The report observed that the individual income threshold had not been adjusted since 1982; the joint income threshold was last adjusted in 1988, and the net worth threshold has been revised since 1982 only once — to exclude the value of a person’s residence. Although the report indicated that inflation had affected the thresholds considerably, the staff did not recommend raising them. Rather, the staff recommended that the SEC leave the current income and net worth thresholds in place, subject to investment limitations; create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations; index all financial thresholds for inflation on a going-forward basis; and revise the definition to allow individuals to qualify as accredited investors based on other measures of sophistication. (See this PubCo post.)
in 2015 and 2016, the SEC Committee on Small and Emerging Companies (which then morphed into the Small Business Capital Formation Advisory Committee), urged the SEC to “do no harm” with regard to the accredited investor definition. And, in the committee’s final meeting in 2017, the members advised against raising the individual income and net worth thresholds, which “would considerably decrease the number of households that qualify as accredited investors,” and have a disparate impact on areas with a lower cost of living (and, typically, lower venture capital activity), as well as on women and minority entrepreneurs. The committee expressed its support for “expanding the definition to take into account measures of sophistication, regardless of income or net worth, thereby expanding rather than contracting the pool of accredited investors. That said, simplicity and certainty are vital to the utility of any expanded definition of accredited investor, so any non-numerical criteria should generally be ascertainable with certainty.” (See this PubCo post.)
In a speech in August 2018, Clayton discussed private capital-raising efforts, acknowledging that the current exemptive framework needed a comprehensive review “to ensure that the system, as a whole, is rational, accessible, and effective,” and indicated that the staff was working on a concept release that would attempt to harmonize the various exemptions. In that regard, he characterized the current framework as “an elaborate patchwork” that would not likely exist as it is if the SEC were starting with blank slate. In particular, he noted:
- “We should evaluate the level of complexity of our current exemptive framework for issuers and investors alike, and consider whether changes should be made to rationalize and streamline the framework.
- For example, do we have overlapping exemptions that create confusion for companies trying to navigate the most efficient path to raise capital?
- Are there gaps in our framework that impact the ability of small businesses to raise capital at key stages of their business cycle?
- “We also should consider whether current rules that limit who can invest in certain offerings should be expanded to focus on the sophistication of the investor, the amount of the investment, or other criteria rather than just the wealth of the investor.
- “And we should take a look at whether more can be done to allow issuers to transition from one exemption to another and, ultimately, to a registered IPO, without undue friction.” (See this PubCo post.)
In a subsequent speech, Clayton noted that among the priority items on the 2019 agenda, Corp Fin was looking at harmonizing and streamlining the “patchwork” private offering system, including whether the accredited investor definition was still appropriate. (See this PubCo post.)
- Rule 701 concept release requesting public comment on ways to modernize Rule 701, particularly the question regarding how, or if, the rule should be modified to reflect changes in the society at large in the relationships between workers—notice I didn’t say “employees”—and companies in the almost 20 years since the rule was last amended. In particular, the release asks whether the conditions for eligibility should be revised in light of the “gig” economy and evolving worker-company relationships. (See this PubCo post.)
- The SEC’s request for comment soliciting input on the content and timing of earnings releases and quarterly reports. The request solicited “public input on how the Commission can reduce burdens on reporting companies associated with quarterly reporting while maintaining, and in some cases enhancing, disclosure effectiveness and investor protections. In addition, the Commission is seeking comment on how the existing periodic reporting system, earnings releases, and earnings guidance, alone or in combination with other factors, may foster an overly short-term focus by managers and other market participants.” Should smaller companies have more flexibility in reporting that would involve a more appropriate “cadence” for smaller companies?
- Rule 404(b) requirement for an auditor attestation regarding the effectiveness of internal control over financial reporting. Currently, the requirement applies to all public reporting companies, other than non-accelerated filers and EGCs. However, Hinman let it be known that, at the open meeting scheduled for later this week, the SEC will consider a proposal to raise the thresholds in the accelerated filer and large accelerated filer definitions, which would have the effect of eliminating the requirement to provide the auditor attestation for the resulting larger group of non-accelerated filers. He also indicated that the proposed test for 404(b) would now include a revenue component, which should be particularly appealing for many biotechs. (Although they may have large market caps (most likely based on breakthrough potential), they are often in the early stages of product development and, therefore, frequently have no or extremely low revenues. As a result, they often have financial characteristics much closer to non-accelerated filers.)
When the SEC adopted changes to the definition of “smaller reporting company” in 2018, it dangled the idea of modifying the SOX 404(b) requirement, but did not act on it at that time, notwithstanding a torrent of criticism of the application of SOX 404(b) to smaller companies. Some of that criticism came from the SEC’s Advisory Committee on Small and Emerging Companies in its final report in 2017. SOX 404(b) has also been scrutinized as a significant contributor to the type of regulatory overload that some argue has deterred companies from conducting IPOs. At a July 2017 hearing of the Subcommittee on Capital Markets, Securities, and Investment of the House Financial Services Committee, a number of the witnesses trained their sights on SOX 404(b), arguing that it was too time-consuming and expensive for smaller companies and diverted capital from better uses, such as R&D. According to another witness, however, an EY report showed that, following the effectiveness of the SOX attestation requirement, from 2005 to 2016, the number of financial restatements declined by 90%, and the aggregate amount of net income involved in restatements declined from $6 billion to $1 billion. Initially, in the first two years after SOX 404(b) went into effect, there were over 1,000 restatements in each year. If SOX 404(b) were eliminated, a witness speculated, the result could very well be that there is no beneficial effect on the number of public offerings, but that the risk of financial scandal has dramatically increased. (See this PubCo post, this PubCo post and this PubCo post and this PubCo post.)
A bipartisan group of senators has introduced a new bill, the Fostering Innovation Act of 2019 (S. 452), that would provide a temporary exemption from the auditor attestation requirements of SOX 404(b) for low-revenue issuers, such as biotechs. The bill is designed to help those EGCs that will lose their exemptions from SOX 404(b) five years after their IPOs, but still do not report much revenue. For those companies, proponents contend, the auditor attestation requirement is too costly, diverting capital from other critical uses, such as R&D. (See this PubCo post.)
- Recently proposed changes to Rules 3-05 and Article 11 of Reg S-X. Under Rule 3-05, acquiring companies must provide separate audited annual and unaudited interim pre-acquisition financial statements of the acquired business, with the number of years required determined on the basis of the relative significance of the acquisition. Among other things, the proposal would reduce the number of years of target audit financials required in M&A transactions from three years to two years for an acquisition that exceeds 50% significance. Hinman observed that the requirement can be costly for many smaller company targets, that may plan for an M&A exit and therefore incur the cost of a financial audit that would not otherwise be required. (See this PubCo post.)
- Longer term, changes to Reg S-K generally, including (i) a move away from bright-line standards to principles-based standards, and (ii) revisions to take into account the transition in the nature of business from the time when S-K was originally adopted, particularly the shift from a company’s key assets consisting primarily of property, plant and equipment to now consisting primarily of intellectual property and human capital.
Committee members, when asked to suggest topics and gray areas that needed to be addressed, identified confusion regarding the types of conduct that constitute general solicitation, whether the offers should continue to be regulated at all (instead of only sales), ways to address the gap in funding between $3M and $20M (which results in part from the increasing proclivity of more funds and institutional investors to focus on more mature investments), the need to simplify the rules for fund-raising by entrepreneurs (which, presumably, will be addressed in the harmonization concept release), clarification of the 12(g) requirement to register under the Exchange Act, and how to increase the opportunity and incentive for local investment.